Will The Pawnee Become The Pawner? DFC Global, Convertibles, And More

Actually, I don’t think there is any such word as “pawnee.” There’s also no such place, except on television, where the show Parks and Recreation takes place. I’ve never been able to get into that show, although in fairness, the only sitcoms I watch are Modern Family and The Neighbors. So maybe I should have headlined “Will The Hock Shop Become The Hocker?” Or something.

DFC Global (NASDAQ:DLLR), which provides a variety of financial services to lower-income people often called the “unbanked,” is descending into its own low-income world. The company formerly known as Dollar Financial Corp, hence the ticker, has a couple of convertible bonds. Anyway, if you were paying attention to the company’s bond situation—convertible and otherwise—you might have foreseen the earnings bomb dropped Thursday evening.

A little background first. I saw management present at a Credit Suisse conference of small-capitalization convertible bond issuers back in the fall of 2012. I liked these guys—I thought they made a good case not only for their business as an investment but also for the social benefits of what they do. Given the general reputation of pawn shops and check cashers, that isn’t easy. I actually decided to buy a few shares for my own account last October at what seemed like a good price at the time, around $12. I thought the stock had a decent chance to get back to the high teens if the company’s argument, that new regulations affecting its United Kingdom business could actually help competitively, proved accurate.

Why didn’t I buy the convertible bonds instead? Both of the issues (ignoring a small stub of an older deal) are convertible in the $20-per-share range, and I was only interested in a small, fairly short-term trade. I was looking for a 40 or 50% gain over a year or so, and given the convertibles’ profile, I doubted they would gain much more than 10% over my time horizon even if my stock view was right. It was a tiny investment, so I didn’t mind forgoing the better downside protection you usually get from convertibles.

The company, like many of its customers, has a lot of debt. The two main convertible deals (which pay 3 and 3.25% annually) total about $386 million. But there’s also a much bigger piece—a $600 million non-convertible bond that pays 10.375%. The bond is technically an obligation of DFC’s Canadian subsidiary, but any way you look at it, you don’t see coupons like that much these days. In mid-November DFC announced that it was going to try to cut a deal to raise new money to pay off the high-coupon bond. While business wasn’t great, the markets still appeared to expect that the company was going to be able to do this, hopefully both lowering its interest expense and extending the maturity beyond December of 2016.

The stock appeared to be working its way higher last fall. Then word got out, just a week after the refinancing plan was announced, that DFC was giving up on the idea. It cited “market conditions”.

Those of us of a certain age may remember the Ohio Players’ song “Love Rollercoaster.” Say what? Exactly. I know that as a DFC shareholder I didn’t like the rollercoaster of that week’s news flow. “Say what?” were exactly the words that came to mind when DFC gave “market conditions” as an excuse. I have worked on Wall Street since the mid-1980’s and I had never—as in never—seen better market conditions for refinancing high-yield debt than last year. Being unable to get a deal done was like being unable to sell water in the Sahara. Something was clearly wrong, far more wrong than the company was letting on. Perhaps something more than the UK issues, and more than gold--which DFC holds as collateral in various forms for certain loans--failing to glitter.

I immediately decided to become a former shareholder. My small gain the day before had turned into a small loss, but I didn’t care. My best quality as a trader is that I never mind taking losses that need to be taken. Quoting Keynes, “When the facts change, I change my opinion. What do you do?”

When I decided to sell, DFC had an equity market capitalization of around $430 million. If the company was having trouble refinancing a $600 million bond coming due in a few years, and also had over $350 million in convertible debt as well, I figured that thin equity cushion was in trouble. A highly dilutive financing—perhaps a new convertible with a much lower conversion price—might be in the offing. The company was probably going to have to do something. It wasn’t quite in dire straits yet, but it wasn’t that far away.

What about the convertibles? Well, at first glance, you might not think they are much of a problem for the company. A cursory look shows that the company must repay $230 million (the 3% bonds) in 2017, while the rest don’t come due until 2027 and 2028. An eternity. The convertibles don’t seem to make things any easier for DFC, but they don’t appear to complicate the main issue, repaying the Canadian bonds.

Ahh, but if you thought that, you’d be wrong. You see, long-fused convertible bonds frequently have options in the not-so-fine print. It turns out that holders of the other $156 million of convertibles have these “put” options, and they can demand their money back a lot sooner—$36 million at year-end 2014 and the balance four months later. Now, these bonds are subordinate to the Canadian debt, but they can still cause a lot of problems. If the company can't repay them, it will have to restructure.

This is still a good ways off. The company still has plenty of cash for now. But if you’re wondering why the stock sold off as sharply Friday as it did, look to these convertibles for a big part of your answer. And, as I said, if you were paying attention, you might have seen this coming.

I am the co-founder and managing principal of Hillside Advisors LLC, a New York City-area consulting firm focused on convertible bonds and related investments. I am a 20-year veteran of the convertible market. My previous employers include Goldman Sachs, Wellesley Investme...